SUMMARY.
Problems resulting from interest rates being too low for too long have spilled over into stockmarkets, and a long over-due correction is underway. Should you be concerned? Are there opportunities?
Regular readers will know that the markets are performing much as we anticipated. No one can ever be sure precisely when a market will tumble and enter a corrective phase, but it is occasionally clear when a correction is due (or overdue), and what the trigger might be. The trigger was, as expected, trouble in credit markets where interest rates, too low for too long, had encouraged the animal spirits of bankers and (hedge) fund managers, who lent and borrowed, respectively, on terms and in volumes which were, to put it mildly, imprudent.
An extraordinarily long period of irrational equanimity has now given way to panic in some quarters. On Thursday the UK stockmarket experienced its biggest fall since 2003, the end of the bear market. Yet on Friday it rose 5.4% from its low. Moreover, the S&P 500, the major US stockmarket and the most significant global barometer, was barely down 10% since its peak in July, which makes it a minor correction.
The latter fact indicates why some of the media reporting must be taken with a pinch of salt.
Is the worst over? Probably not. Should you be worried? Probably not.
The damage at various banks and hedge funds is not yet clear, and this uncertainty could prompt more volatility. In the short term we can see the market both rallying to 6300, and falling away to 5500 (to complete the correction and allow the uptrend to continue). However experience tells us that trying to finesse buying and selling in this environment is fruitless and frustrating, and the key remains a balanced portfolio taking a multi-year view. These sorts of corrections are vital to the well-being of the stockmarket, ensuring that investors don’t become too (dangerously) complacent about risk, and that the foundation is laid for the next upswing.
Beyond this short term volatility, you will recall from previous instalments that, generally, the lower the price earnings ratio of the stockmarket, the greater the attractions. Based on the current FTSE 100 level of 6100, the prospective dividend yield is 4.2% and PE ratio 10.8. On this basis the UK stockmarket is 25% cheaper than in March 2003 when the FTSE 100 index was at its bear market low around 3300. The oil and gas sector is even better value, 36% lower than in 2003 – see the article on opportunities in energy funds in the latest TopFunds Guide, 12th edition.
If volatility in financial markets is contained in the next month or so, the impact on the real economy should remain limited, and the confidence of consumers and business leaders should be sufficiently robust to ensure that a recession is avoided in 2008. Even so, if our analysis proves too relaxed, last Friday the Federal Reserve in the US, recognising a possible spill-over into the real economy, confirmed it will act to cut rates if required.
Opportunities? For those that have cash ready to invest there are outstanding opportunities. We have already mentioned the energy sector. There are now a growing number of very large UK businesses with dividend yields higher than you will receive on deposit, with the prospect of steady dividend growth and improving capital values. A number of outstanding fund managers have been increasingly concentrating on these larger companies in recent times. If investing a lump sum now would be a little too nerve-wracking, drip feeding over a few months removes the need to try and fine-tune your timing.
